The Phillips Curve Economic Theory Explained

What Is the Phillips Curve?

The Phillips curve is an economic theory that inflation and unemployment have a stable and inverse relationship. Developed by William Phillips, it claims that with economic growth comes inflation, which in turn should lead to more jobs and less unemployment.

The original concept of the Phillips curve has been somewhat disproven due to the occurrence of stagflation in the 1970s, when there were high levels of both inflation and unemployment.

Understanding the Phillips Curve

The concept behind the Phillips curve states the change in unemployment within an economy has a predictable effect on price inflation. The inverse relationship between unemployment and inflation is depicted as a downward sloping, convex curve, with inflation on the Y-axis and unemployment on the X-axis. Increasing inflation decreases unemployment, and vice versa. Alternatively, a focus on decreasing unemployment also increases inflation, and vice versa.

The belief in the 1960s was that any fiscal stimulus would increase aggregate demand and initiate the following effects. Labor demand increases, the pool of unemployed workers subsequently decreases and companies increase wages to compete and attract a smaller talent pool. The corporate cost of wages increases and companies pass along those costs to consumers in the form of price increases.

This belief system caused many governments to adopt a "stop-go" strategy where a target rate of inflation was established, and fiscal and monetary policies were used to expand or contract the economy to achieve the target rate. However, the stable trade-off between inflation and unemployment broke down in the 1970s with the rise of stagflation, calling into question the validity of the Phillips curve.

The Phillips Curve and Stagflation

Stagflation occurs when an economy experiences stagnant economic growth, high unemployment and high price inflation. This scenario, of course, directly contradicts the theory behind the Phillips curve. The United States never experienced stagflation until the 1970s, when rising unemployment did not coincide with declining inflation. Between 1973 and 1975, the U.S. economy posted six consecutive quarters of declining GDP and at the same time tripled its inflation.

Expectations and the Long Run Phillips Curve

The phenomenon of stagflation and the break down in the Phillips curve led economists to look more deeply at the role of expectations in the relationship between unemployment and inflation. Because workers and consumers can adapt their expectations about future inflation rates based on current rates of inflation and unemployment, the inverse relationship between inflation and unemployment could only hold over the short-run.

When the central bank increases inflation in order to push unemployment lower, it may cause an initial shift along the short-run Phillips curve, but as worker and consumer expectations about inflation adapt to the new environment, in the long-run, the Phillips curve itself can shift outward.

This is especially thought to be the case around the natural rate of unemployment or NAIRU (Non Accelerating Inflation Rate of Unemployment), which essentially represents the normal rate of frictional and institutional unemployment in the economy. So in the long-run, if expectations can adapt to changes in inflation rates then the long-run Phillips curve resembles a vertical line at the NAIRU; monetary policy simply raises or lowers the inflation rate aftermarket expectations have worked themselves out.

In the period of stagflation, workers and consumers may even begin to rationally expect inflation rates to increase as soon as they become aware that the monetary authority plans to embark on expansionary monetary policy. This can cause an outward shift in the short-run Phillips curve even before the expansionary monetary policy has been carried out, so that even in the short run the policy has little effect on lowering unemployment, and in effect, the short-run Phillips curve also becomes a vertical line at the NAIRU.

The Bottom Line

The Phillips curve is an economic theory positing an inverse relationship between inflation and unemployment. It resonated with economists in the 20th century, but became increasingly disputed in the 1970s, which saw rising unemployment and inflation simultaneously. Today, economists have adapted new models to explain the relationship between unemployment and inflation. However, some economists still maintain that the Phillips curve is useful to consider, despite its limitations.